Foreign Direct Investment and Product Quality in Host Economies

This paper examines, both theoretically and empirically, how the presence of foreign-invested firms (i.e., foreign direct investment, FDI) affects the product quality of domestic firms. In a monopolistically competitive market with Melitz (2003) style heterogeneous firms, we show that, if consumers derive higher utility from consuming higher quality products, then despite the fact that product quality is not directly observable, one can identify the impact of FDI on product quality from its impact on firm revenue and cut-off capability. We show that the presence of foreign-invested firms affects the product quality of domestic firms through (i) a direct channel via productivity spillovers in both goods and quality production and (ii) an indirect channel via its impact on cut-off capability. The overall impact of FDI on the product quality of domestic firms depends on the relative strengths of these two contrasting effects. In the second part of the paper, using firm level data, we estimate this impact in China’s beverage manufacturing industry. We find that, despite the presence of positive productivity spillovers from foreign-invested to domestic firms in goods production, a one percent increase in foreign presence decreases the expected product quality of domestic firms by more than ten percent.